RBI monetary policy: Is flexible inflation targeting working well in India?

It will soon be two years since RBI’s monetary policy shifted to flexible inflation targeting. What has been the record till now?

The government suppressed farm prices to help the Reserve Bank of India (RBI) keep headline inflation near target. Photo: HT

The six members of the monetary policy committee of the Reserve Bank of India (RBI) are scheduled to meet next week to decide the future trajectory of interest rates. Most expect the committee to keep the cost of money at current levels. This column asks a broader question. It will soon be two years since Indian monetary policy shifted to flexible inflation targeting. What has been the record till now?

There is little doubt that consumer price inflation has come down sharply over the past two years. However, some deeper changes in Indian inflation dynamics have been highlighted in a new paper by Ravindra H. Dholakia of the Indian Institute of Management, Ahmedabad, and Virinchi S. Kadiyala of ICICI Bank (Changing Dynamics Of Inflation In India, Economic And Political Weekly, 3 March 2018). Dholakia is also perhaps the most dovish member of the committee that sets Indian policy interest rates. These deeper changes in inflation dynamics deserve more public attention.

There was a sharp debate preceding the shift to a flexible inflation target about which measure of inflation the Indian central bank should target. India was then in the midst of an inflation crisis. Steep increases in food prices had spilled over into the general price level after 2010. The Urjit Patel committee pointed out in its 2014 report that food or fuel price inflation quickly gets generalized because of inflation expectations. The committee suggested that Indian monetary policy should thus target headline inflation rather than core inflation.

Many countered by pointing out that the Indian consumer price index is dominated by food prices, and the prices move because of supply shocks rather than monetary policy. This column had argued in October 2013 that India was already moving towards a monetary policy framework that focused on core inflation (https://goo.gl/6CziB4). Some, such as Harish Damodaran, also argued that the policy of targeting headline inflation implicitly led to deflation in farm prices, and thus hurt farmers. The government suppressed farm prices to help the RBI keep headline inflation near target (there is also good reason to ask whether the central bank in a developing economy should also be sensitive to other factors such as exchange rates and financial stability).

The Dholakia and Kadiyala paper reopens some of these debates. The economists make two central points.

First, inflation persistence has decreased in recent years. Shocks to core inflation dissipate in some time rather than leading to a higher level of inflation.

Second, sudden movements in food and fuel prices do not lead to permanent changes in headline inflation. The reason: Inflation expectations are now anchored. Headline inflation reverts to core inflation. It was the other way around earlier, when core inflation would either rise or fall to come closer to headline inflation.

Both these profound changes are likely explained by the fact that inflation expectations are more stable since the introduction of flexible inflation targeting two years ago, or that citizens are not changing their assessments of future inflation based on every shift in volatile items such as food prices. It also means that the credibility of Indian monetary policy has been rebuilt to some extent, even though inflation expectations are still higher than the inflation target. However, these are still early days, and the new monetary policy framework has not yet been severely tested.

There are several important lessons from the change in Indian inflation dynamics over the past few years.

First, as inflation expectations stabilize, it makes sense for the RBI to look past sudden shock to core inflation such as the price impact of the move to the goods and services tax (GST) or a hike in the house rent allowance (HRA) paid to government employees. The case of food or fuel price shocks is more complicated, but monetary policy need not hastily respond to temporary price shocks, either by increasing or slashing interest rates. Dholakia and Kadiyala warn that a “strong response to volatile prices would run the risk of time inconsistency, and also ultimately result in expanding the output gap”.

Second, policymakers should be giving greater weightage to core inflation than before, not just in policy discussions but also in forecasting models. The RBI’s own inflation forecasting model—the Forecasting and Policy Analysis System—has parted ways with standard central bank forecasting models by taking a disaggregated look at food, fuel and core inflation.

Third, there are two equal halves of the economy—a food sector with flexible prices and a non-food sector with sticky prices. Managing the two with a common monetary policy is a tricky job. Even the motivations of the people in these two sectors are different. Producers in the non-farm economy look ahead to make their decisions while producers in the farm economy look back (think of the cobweb model taught to undergraduate economics students).

Flexible inflation targeting seems to have scored some important early victories in India. The stabilization of inflation expectations as well as the growing credibility of monetary policy means that monetary policy need not respond frantically to every unexpected shift in price levels. In fact, the pressure on the RBI to react to every unexpected move in inflation usually shows a profound lack of understanding of what flexible inflation targeting is all about.